A majority of corporations provide access to life insurance benefits for their employees. That benefit is typically provided through group term life insurance. In traditional group term plans, the employee designates the beneficiary of the contract. Depending on the plan design, the cost of this benefit may be subsidized by the employer.
Most employee welfare benefit plans that provide death benefits are funded in whole or in part by "experience-rated" group term life insurance. Under a typical experience-rated arrangement, the employer will pay a provisional premium to the insurer at the beginning of each policy period. When an employee dies, the insurance company pays a specified death benefit to the employee's beneficiary. If the total death benefits paid out in any given policy period are greater than the provisional amount paid by the employer, the employer must then pay the shortfall to the insurance company. Conversely, if the amount of benefits paid by the insurance company turns out to be less than the employer's provisional premium, the company refunds the excess to the employer.
The delivery of the benefit through experience-rated term life insurance arrangements creates a number of disadvantages from both the employer and the employee's perspectives. Such programs do not provide the employer with any protection against the risk that an unexpectedly large number of employees might die in any given policy period. In such an event, the employer is faced with the full financial burden of paying the employee death benefits.
In addition, under Internal Revenue Code, Section 79, which governs group term life insurance, the employee is faced with imputed income on any company-paid life insurance coverage in excess of $50,000. The amount of imputed income mandated by this Section is typically significantly higher than the actual cost of the coverage, resulting in additional taxation to the employee. At termination or retirement, the employee's only option with respect to maintaining his or her coverage is to convert the group term insurance policy to a whole life insurance policy which, in many instances, may cost 20 to 30 times more than the cost of the benefit while he or she was employed.
Consequently, in recent years employers have provided limited company paid group term life insurance benefits (typically limited to a maximum of $50,000 per employee) and have arranged for employees to purchase additional group term life insurance in amounts of some multiple of the individual's salary on a voluntary basis. Such additional voluntary insurance costs may be subsidized by the employer and the employer provides some administrative services and collects the employee's premiums through payroll deductions for the insurance company.
This conventional arrangement is illustrated in EMPLOYEE portion A of FIG. 1. As can be seen in FIG. 1, the employer 10 pays the voluntary group life premium 12, usually as a payroll deduction from the employee's net pay 11. The premiums 12 are held in a general account 14. Upon the death of an active employee 16, a group term death benefit 18 is paid out of the general account 14 directly to the employee's beneficiary.
Unrelatedly, employers have purchased permanent whole life insurance policies for the purpose of funding employee benefits and other expenses. Such policies are generally referred to as corporate owned life insurance (COLI) contracts. With such contracts, the employer is the owner/beneficiary and the employee is the insured. COLI contracts are usually comprised of a cash value or savings portion and a term death benefit portion. Because of the tax treatment of life insurance contracts, the COLI contracts are attractive investments which can provide funds for various deferred expenses of the employer.
This conventional arrangement is illustrated in EMPLOYER portion B of FIG. 1. The employer 10 pays a premium which is divided into the COLI cash value premium 20 and a COLI term premium 22. The COLI term premium 22 is deposited in the general account 14, but the COLI cash value premium 20 is deposited into a separate account 24. The insurer 26 separately manages the general account 14 and the separate account 24. Upon the death of an employee, the COLI term portion of the death benefit 28 is paid out from the general account 14 to the employer, while the COLI cash value portion of the death benefit 30 is paid out of the separate account to the employer. The benefits 30 are used to fund the employee benefits and other expenses 19.
A number of major potential problems exists with the use of COLI contracts including the question of an employer's insurable interest in a broad base (large numbers) of employees, the selection of the proper amount of insurance for each insured employee, concern over whether to disclose the existence of such insurance to the employee, the potential for a claim from an employee's estate or beneficiaries for some or all of the death benefits, and the like.
Because of the problems associated with existing experience-rated group term and COLI products, many employers have expressed interest in alternative life insurance arrangements, that limit the risks to which employers are exposed and at the same time minimize the adverse tax consequences to employees and provide an attractive savings elements for employer funds. One such alternative that has been considered is a concept referred to as "split dollar insurance". This is an arrangement which takes a single life insurance policy issued on an individual policy basis and splits the premium and benefits between the employer and employee.
There are several major problems with traditional split dollar insurance. One is that it has been limited to only highly compensated employees. For ERISA purposes, most commentators are comfortable that you can rely on the top hat exemption for highly compensated employees, but for employees falling below that level, ERISA restrictions would apply. For a general discussion of these restrictions, see Richey et al., Comprehensive Deferred Compensation, National Underwriting Co., Chapter 5, pp. 29-38, 1989, and Jenkins et al, "ERISA Planning for COLI Financed Nonqualified Plans", Journal of the American Society of CLU and ChFC, pp. 24-36, January 1991.
With regard to employees that are not at the top level of the company, the question has been to what extent should the cash value of the policy be considered a plan asset for ERISA purposes, If the entire policy including the cash value was regarded as an asset of an employee benefit plan, then the employer's exercise of rights of ownership with respect to the policy could be viewed as prohibited transactions and in violation of ERISA. Another major problem has been the higher insurer expenses inherent in the pricing of individual life insurance policies.
Also, because of the nature of individual policies, termination of employment requires that the employer terminates its interest in the contract. The employee continues his or her interest only if he or she assumes the cost and tax consequences of the entire contract.